INTRODUCTION TO TAXATION Unlike most transfers, which are voluntary, taxation is compulsory. That’s needed because of free-rider problem (no one will have injective to contribute) Modern taxes are monetized (individuals provide just money) Tariffs are taxes imposed on imported goods. Tariffs protect domestic producers. Taxes can be divided to: • direct • indirect Direct taxes are individual income tax, payroll tax (used to finance social) security, corporation income tax (tax on net profit of corporations), tax on property.
Indirect taxes are custom duties on imported goods from abroad, exice taxes (telephone services, air travel, luxury commodities).
VAT (Value-added tax) are taxes on the difference of value of sale and value purchased. Income tax makes a biggest percent in the tax revenue in the USA. USA relies much more on the individual income tax, unlike EU countries which rely on VAT. Five properties of a good tax system: ? efficiency (it should not be distortionary) ? administrative simplicity (low cost of administration and complexity) ? flexibility (easy adaptation to changing circumstances) ? olitical responsibility (it should be transparent) ? fairness (treating those in similar circumstances similarly) Efficiency – Most taxes change relative prices, so the prices are distorted and the allocation of recourses is inefficient (windows tax in Britain in XVII century) Behavioral effects of taxation – marriage, divorce, risk taking, saving.
Financial effects of taxation – Fringe benefits, financial structure of firms. Organizational effects – Corporations vs unincorporated enterprises, banks vs insurance companies.
General equilibrium rate effect is that tax on income reduces saving and reduced saving are reducing capital. Reduced capital means reduced productivity of workers and their wages.
Announcement effects and impact affect also affect tax system. Nondistortionary taxation – There is nothing that individual or a firm can do to avoid tax liability. These are called lump-sum taxes. Head tax (the one that has to pay regardless of income or wealth), Tax on commodities are distortionary (buying less, paying less tax. Tax on icome are also distortionary taxes.
Corrective taxes are raising revenue and improve efficency of resource allocation (taxes on externalies). Administrative costs : – Direct costs (running the Internal revenue service) – Indirect costs (borne by tax buyers) Indirect costs are twice times greater than direct. Administrative costs depend of what records would be kept in the absence of taxation and it’s complexity. Flexibility – Changes in economic circumstances require changes in tax rates. Automatic stabilization – If economy goes into a recession, a reduction of taxes is desirable.
When prices are stable, progressive structure will provide automatic stabilization. Indexing taxes in this case are destabilizing economy. Political difficulties of adjusting rate and speed of adjustment (speed which changes in the tax code can be implemented) effect the flexibility of taxes. Political responsibility is connected with transparency. Transparency is defined by when it’s clear who is benefiting and who is paying. From perspective of transparency, corporation tax is one of the worst, because the one who really payes the tax is not apparent. Fairness is connected with horizontal equity and vertical equity.
Horizontal equity is where individuals who are the same in the all relevant respects are treated the same. Vertical equity is that some individuals who are in a position to pay higher taxes than other should do so. Basis of taxation are : ? income (replaced by many countries with VAT which taxes just consumption) ? consumption (C = Y – S) ? lifetime income (present dicounted value of the individuals wage income) The benefit approach – Individuals should contribute to the support of the government in the proportion to the benfit they receive from public services.
Parreto efficient tax system – Tax structures such that, given the tools and information available to the government no one can be made better of without making someone worse off. Utilitarianism – The taxation of rich individuals at higher rates than poor individuals. Taxes should be such that marginal utility of income – the loss in the utility from taking a dollar away from and individual should be the same for all individuals. Utilitarianism may implay horizontal inequity (shipwrecked crew) Rawlsian Social welfare function – Maximizing the welfare of the worst off individuals.
TAX INCIDENCE The tax burden is the true economic weight of tax. It is the difference between the individuals real income before and after the tax has been imposed. Incidence is economic term for burden, that’s who actually pays in the sense that their real income is lowered. If wages fall, tax has been shifted backward. If wages fall by full amount of the tax, they have been fully shifted. If prices rise, tax has been shifted forward. Taxes are said to be equivalent when taxes are imposed differently but they can have identical effects.
Tax incidence in competitive markets – When tax is imposed, effective cost of production has been increased by amount of the tax and the supply curve has shifted by the amount of the tax. It makes no difference whether a tax on a commodity is imposed on consumer or producer. Ad valorem tax is a tax levied as a given percentage of the price. Specific tax is a tax given fixed amount per unit of output. In a competitive market, the incidence of an ad valorem and an equivalent specific tax are identical. With a perfectly elastical supply curve, the prices rises by the full amount of tax, entire tax burden is on a consumer.
With perfeclty inelastic demand price rises by full amount of the tax and the entire burden is on consumers. OPTIMAL TAXATION Fallacies of optimal taxation : 1. We should have a tax on wage income. Additional taxes just increase distortions and economic inneficiency. 2. Theory of the second best is the design of government policy in situations where the economy is characterized by some important distortion that can’t be removed. Optimal tax structure is a set of taxes which maximizes social welfare. If all individuals were identical and were treated for tax purposes identicly, a lump-sum tax would be the only efficent tax.
The choice facing the government is to either have a uniform lump-sum tax (individual pays tax regardless of what they do or what abilites they have) or tax that depends on easily measured variables (expenditure or income) Progressive taxes are reducing deadweight loss. Elasticily optimits – distortions are low. Elasticly pessimists – Distortions are large. Flat rate taxes are taxes where the marginal tax rate (the extra tax individual pays for an extra dollar of income) is constant for both tax systems. Progressive tax – the ratio of the total tax payments to the individuals income, increases with income.
More equalitarian social welfare functions will choose more progressive tax system. The basic principles of progressive tax : ? impose high average tax rates with low marginal tax rates ? make a few people as possible face high marginal tax rates ? impose high marginal tax rates on those for whom the tax is a lest distorting. Differential taxation – Taxes that are imposed at different rates on different commodities. Ramsey taxes – The comodity taxes that minimize the deadweight loss. TAX AVOIDANCE Tax avoidance entails taking full advantage of the provisions of the tax code to reduce one’s tax obligations.
Tax avoidance entails compliance with tax laws by using provision of the tax codes that allows them to escape paying taxes or to reduce tax obligations – loopholes. Two basic principles of tax avoidance : – postponement of taxes – taking advantage of differences in tax rates for different types of incomes Postponements of taxes : – accounting tricks – capital gains and the postponement of taxes Taking advantage of differences in tax rates : – income shifting – corporate shifting – capital gains – tax arbitrage (entails taking advantage of the different rates at which different kinds of income or different individuals are tayed)
Tax shelters – Investment schemes that reduce one’s tax liabilites. It exists when deductions from one income source can be offset against income from another source. REFORM OF THE TAX SYSTEM ? Increased fairness ? Improved efficiency ? Reduced adminstrative costs Fairness – eliminating special provisions, capital taxation, vertical equity. Efficency – Laffer tax curve. FISCAL FEDERALISM The federal government affects the states and localities in a variety of other ways, besides providing grants. It’s regulations and the federal tax code affect states and localities, just as they affect private businesses.
Ineractions between the federal government and the state and local governments : – regulations – incentives (grant) – tax expenditures Fiscal federalism is the division of economic responsibility between the federal government and the states and localities. The division of responsibilities : – Matching grant (state determines level of expenditure) and federal government pays a fraction of cost – Block grant (fixed amount of money) and state bears the full costs of any expenditure above that amount – General revenue sharing – providing block grants that could be used for any purpose
National public goods are public good whose benefit are available for everyone in the nation. Local public goods are public goods whose benefits are limited to those living in a locality. International public goods are public goods whose benefits are global in nature. Tiebout hypothesis – Just as competition among private firms leads to the efficient provision of private goods, so to competition among local communities leads to efficency in the provision of local public goods. Limitations of Tibebout hypothesis are : – Market failures (externalies, imperfect competition) – Tax competition that leads to lower taxes on business Redistribution Market failures are externalies and imperfect competition. Redistribution is inequality among individuals and among communities. DEFICIT FINANCE Sources of deficit problem : ? Reduced federal taxes ? Higher defense spending ? Higher social spending on the elderly ? Increasing health care expenditures ? Higher interest payments Entitlement programs are programs like social security and Medicare where the government defines eligbility criteria for certain benefits, actual expenditures then dpend on how many people meet those criteria and what those benefit costs.
Discretionary programs – government sets the expenditure levels on an annual basis. Public investments are complement to private investments. USA was in much of a federal debt during 1980’s. By borrowing, the government places the burden of reduced consumption on future generations. Reagan’ spending on deffence made government debt impossible to control during 1980’s. Deficit was brought under control in the late 1990s, through increased taxes, reduced expenditures, especially on defense.
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